Case #2 - FI

Case Report # 2 F1-300 11/22/2016 Japke Welschen - Introduction Shipper Electronics, has embarked upon an expansion project, which has the potential of increasing sales by about 30% per year over the next 5 years. As CFO of Shipper Electronics, I have to analyze this potential project and see what is the best way of financing this. Our board of directors could not agree on a final decision. After answering a few key questions below, and analyzing the financial statements , I would like to give my suggestion for Shipper Electronics in which route of financing to choose. The goal will be to make a capital structure decision that is designed to maximize the firms intrinct value. Assignment: Please present your results in a typed professional report. Please include a cover page for the report. Points will be awarded for presentation and clarity as well as accuracy. Situation: Mark’s company, Shipper Electronics, had embarked upon an expansion project, which had the potential of increasing sales by about 30% per year over the next 5 years. The additional capital needed to finance the project had been estimated at $5,000,000. Mark was considering whether he should burden the firm with fixed rate debt or issue common stock to raise the needed funds. Having had no luck with getting the board of directors to vote on a decision, Mark decided to call on Steve Berry, his Chief Financial Officer, to shed some light on the matter. Mark Shipper, the Chief Executive Officer of Shipper Electronics, remembered vividly how easily he had managed to get the company up and running by using $3,000,000 of his own savings and a five-year bank note worth $2,000,000. He recollected how uneasy he had felt about that debt burden and the 14% per year rate of interest that the bank had been charging him. He remembered distinctly how relieved he had been after paying off the loan one year earlier than its five-year term, and the surprised look on the bank manager’s face. Business had been good over the years and sales had doubled about every 4 years. As sales began to escalate with the booming economy and thriving stock market, the firm had needed additional capital. Initially, Mark had managed to grow the business by using internal equity and spontaneous financing sources. However, about 5 years ago, when the need for financing was overwhelming, Mark decided to take the company public via an initial public offering (IPO) in the over-the-counter market. The issue was very successful and oversubscribed, mainly due to the superb publicity and marketing efforts of the investment underwriting company that Mark had hired. The company sold 1 million shares at $5 per share. The stock price had grown steadily over time and was currently trading at its book value of $15 per share. When the expansion proposal was presented at the last week’s board meeting, the directors were unanimous about the decision to accept the proposal. Based upon the estimates provided by the marketing department, the project had the potential of increasing revenues by between 10% (Worst Case) and 50% (Best Case) per year. The incremental rate of return was expected to far outperform the company’s hurdle rate. Ordinarily, the project would have been started using internal and spontaneous funds. However, at this juncture, the firm had already invested all it internal equity into the business. Thus, Mark and his colleagues were hard pressed to make a decision as to whether long-term debt or equity should be the chosen method of financing this time around. Upon contacting their investment bankers, Mark learned that they could issue 5-year notes, at par, at a rate of 10% per year. Conversely, the company could issue common stock at its current price of $15 per share. Being unclear about what decision to make, Mark put the question to a vote by the directors. Unfortunately, the directors were equally divided in their opinion of which financing route should be chosen. Some of the directors felt that the tax shelter offered by the debt would help reduce the firm’s overall cost of capital and prevent the firm’s earning per share from being diluted. However, others would not be convinced. They were of the opinion that it would be better for the firm to let investors leverage their investments themselves. They felt that equity was the way to go since the future looked rather uncertain and being rather conservative, they were not interested in burdening the firm with interest charges. Besides, they felt that the firm should take advantage of the booming stock market. Feeling rather frustrated and confused, Mark decided to call upon his chief financial officer, Steve Berry, to resolve this dilemma. Steve knew that he was in for a challenging task. In preparation of his presentation, he got the latest balance sheet and income statement of the firm (see Tables 1 and 2) and started crunching out the numbers. Questions: 1. If Shipper Electronics Inc. were to raise all of the required capital by issuing debt, what would the impact be on the firm’s shareholders? (Note: The impact on shareholders can be analyzed by calculating the EPS and ROE of the firm under alternative scenarios). If Shipper Electronics Inc. were to raise all of the required capital by issuing debt, the effect of issuing this debt will be: Debt holders have prior claim to cash flows relative to stockholders. The debt holders “fixed” claim increases risk of stockholders “residual” claim so the cost of equity will go up. Reduces interest expense. Frees up more cash for payments to investors. reduces the after cost of debt. Debt increases the risk of bankruptcy. Because there is more risk than before, the required return expected by investors will go up. Adding debt increases percent of firm finances with low-cost debt (Wd) and decreases percent finances with high-cost equity (Ws) Current Sales $ 15,000,000 EBIT $2,250,000 Net Income $1,350,000 Equity $15,000,000 ROE= NI/ Equity = 1,350,000/15,000,000=0.09=9% If Sales increases 10% (Worst Scenario ) Sales $15,000,000*1.10=16,500,000 EBIT $2,250,000+($2,250,000*.10)=2,475,000 Debt interest $5000,000*.10=500,000 EBT $2,475,000-500,000=1,975,000 Net Income $1,975,000-($1,975,000*40)=1,185,000 Equity $15,000,000 ROE=NI/ Equity = 1,185,000/15,000,000 = 0.079=7.9% If Sales increases 30% Sales $15,000,000*1.30=$19,500,000 EBIT $2,250,000+($2,250,000*.30)=2,925,000 Debt interest $5000,000*.10=500,000 EBT $2,925,000-500,000=2,425,000 Net Income $2,425,000-($2,425,000*40)=1,455,000 Equity $15,000,000 ROE=NI/ Equity = 1,455,000/15,000,000 = 0.097=9.7% If Sales increases 50% (Best Scenario ) Sales $15,000,000*1.50=$22,500,000 EBIT $2,250,000+($2,250,000*.50)=3,375,000 Debt interest $5000,000*.10=500,000 EBT $3,375,000-500,000=2,875,000 Net Income $2,875,000-($2,875,000*40)=1,725,000 Equity $15,000,000 ROE=NI/ Equity = 1,725,000/15,000,000 = 0.115=11.5% Looking at the ROE results we can see that by issuing debt, the shareholders will get a higher return. Especially with the sales increase of 30&50%. Question: 2. What is the current weighted average cost of capital of the firm? What effect would a change in the debt-to-equity ratio have on the weighted average cost of capital and the cost of equity capital of the firm? WACC = ((E/V) * Re) + [((D/V) * Rd)*(1-T)] E = Market value of the company's equity D = Market value of the company's debt V = Total Market Value of the company (E + D) Re = Cost of Equity Rd = Cost of Debt  T= Tax Rate Given data from the question below we can plug in the numbers: ß = 1.1 rf = 4% rm = 12% WACC = [(1 - t) Rdebt (D /( D + E ))] + Requity (E/(D+E)) Requity ( no debt) = rf + ß (rm – rf) = 4% + 1.1 (12% - 4%) = 12.8% Current WACC = [(1 - t) Rdebt (D /( D + E ))] + Requity (E/(D+E)) WACC= [(1-.40) 0 (0/(0 + $15,000,000))] + 12.8% ($15,000,000/(0+$15,000,000)) =0+12.8% Required Return with no debt = Rf+B (Rm-Rf) .004+1.1(.12-.004)=12.8% Required Equity WITH debt. = R no debt + (R no debt – interest rate on debt) (D/E) (1-tax rate) = 12.8% + (12.8% - 10%) ( $5,000,000/ $ 15,000,000)( 1- 40%) = 12.8% + (2.8%) (0.333) (0.6) = 12.8% + 0.0056 = 0.1336 =13.36% WACC with debt = [(1 - t) Rdebt (D /( D + E ))] + Requity (E/(D+E)) = [(1 – 40%) 10% ($ 5,000,000 /( $ 5,000,000 + E$ 20,000,000))] + 13.36%($ 15,000,000/($ 5,000,000 +$ 15,000,000)) = (0.6) (10%) (0.25) + (13.36%) (0.75) = 0.015 + 0.1002 = 0.1152 = 11.52% The effect on change in debt: The WACC with debt is 11.52% decrease from current WACC as much as 1.28%.it is good for the company, because the lower the WACC the lower of cost of capital. 3. The firm’s beta was estimated at 1.11. Treasury bills were yielding 4% and the expected rate of return on the market index was estimated to be 12%. Using various combinations of debt and equity, under the assumption that the cost of debt stays constant, show the effect of increasing leverage on the weighted average cost of capital of the firm. Is there a particular capital structure that maximizes the value of the firm? Draw the trade-off between the value of the firm and debt ratio. D : E E : V D : E ß Requity WACC debt 1.1 12.8% 12.8 % 0 1 : 10 9 : 10 1 : 9 1.1 12.8% 12.12% $ 5,000,000 2 : 10 8 : 10 2 : 8 1.1 12.8% 10.84% $ 6,000,000 3 : 10 7 : 10 3 : 7 1.1 12.8% 9.56% $ 7,000,000 4 : 10 6 :10 4 :6 1.1 12.8% 7.68% $ 8,000,000 Using various combinations of debt and equity, with the assumption that the cost of each component stays constant, the increasing leverage makes the WACC is getting lower. There is a particular capital structure that maximizes the value of the firm, when a levered firm increases in proportion to D : E, expressed in market values is getting higher. 5. How would the key profitability ratios of the firm be affected if the firm were to raise all of the capital by issuing 5-year notes? Current 10% 30% 50% P/M $ 1,350,000/$15,000,000= 9% $1,185,000/ $16,500,000= 7% $1,455,000/ $19,500,000= 7% $1,725,000/ $22,500,000= 8% BEP $ 2,250,000/ $15,000,000= 15% $ 2,475,000/ $20,000,000= 12% $ 2,925,000/ $20,000,000= 15% $ 3,375,000/ $20,000,000= 17% ROA $1,350,000/ $15,000,000= 9% $1,185,000/ $20,000,000= 6% $1,455,000/ $20,000,000= 7% $ 1,725,000/ $20,000,000= 9% ROE $1,350,000/ $15,000,000= 9% $ 1,185,000/ $15,000,000= 8% $ 1,455,000/ $15,000,000= 10% $ 1,725,000/ $15,000,000= 12% Based on profitability ratio  P/M : bad  BEP : good  ROA : good  ROE : good So, it is good for the company if it issues 5-year notes. 6. If you were Andrew Lamb, what would you recommend to the board and why? If I were Andrew Lamb I would recommend the firm to issues 5-year notes to the bank because based on the calculation of profitability ratios the result is good especially in ROE that measures the rate of return of common stockholders’ investment. Beside that I also considered about WACC and EPS, it showed that there were a lower WACC which was good when the firm using debt, and there was a higher EPS as well means that the earning of selling shares is getting higher. Notes that, the increasing sales have to be above 30%. 7. What are some issues to be concerned about when increasing leverage? Some issues to be concerned about when increasing leverage:  Profit Profit is one of the company’s powers to run the business. We need to be concerned about the profit because we have to know whether our profit is enough to pay the debt and its interest.  Interest rate When we are increasing leverage, we must consider about its interest rate. Whether it is high or not. 8. Is it fair to assume that if profitability is positively affected in the short run, due to higher debt ratios, the stock price would increase? Explain. It is unfair to assume that profitability is positively affected due to the higher debt ratio because to calculate profitability ratio that consist of P/M, BEP, ROA, and ROE. No matter how much the amount of debt if the profit is increasing significantly the stock price will increase as well. 9. Using suitable diagrams and the data in the case explain how Andrew Lamb could enlighten the board members about Modigliani and Miller’s Propositions I and II (with corporate taxes) MM’s proposition I Value levered. The value of a firm is unaffected by its capital structure. It shows that under the ideal conditions the firm debt policy should not matter to the shareholders. MM’s proposition II The required rate of return on equity as the firms’ deincrease bt equity ratio increases. It states that the expected rate of return on the common stock of a levered firm increases in proportion to debt equity ratio (D/E), expressed in market value. Conclusion: Consider of the calculation above we can see that: Using debt:  ROE current 9% Increasing sales 10% 7.9% Increasing sales 30% 9.7% Increasing sales 50% 11.5%  EPS Increasing sales 10% $ 1,185 Increasing sales 30% $ 1,455 Increasing sales 50% $ 1,725 Number of shares 1,000,000 Using homemade leverage (no debt)  ROE current 9% Increasing sales 10% 7.43% Increasing sales 30% 8.78% Increasing sales 50% 10.13%  EPS Increasing sales 10% $ 1,11 Increasing sales 30% $ 1,32 Increasing sales 50% $ 1,52 Number of shares 1,000,000 + 333,333.33 = 1,333,333.33 shares The higher profitability ratio using debt reflects that the company’s condition is good in the term on returning on common stockholders investment. And the EPS is higher than using homemade leverage means that the earnings per share is good when using leverage. Notes that the company has it sells above 30%. The risk is when the increasing sales are just 10%. But the principle is the higher the risk, the higher the return. Therefore it is the responsibility f the firm to increase it sells to get higher return or profit. It is supported by the calculation of WACC that shown in number 4, that the higher the debt the lower the WACC. It is good for the company. If I were Andrew Lamb I will suggest to the Symonds Electronic Inc. to expand its business by using leverage. 4. How would the key profitability ratios (ROE and ROA) of the firm be affected if the firm were to raise all of the capital by issuing 5-year notes. 5. If you were Steve Berry, what would you recommend to the board and why? 6. Is it fair to assume that if profitability is positively affected in the short run, due to the higher debt ratio, the stock price would increase? Explain.